Definition of Liabilities
Liabilities are a company’s obligations and are usually defined as a claim on the company’s assets. However, liabilities (and stockholders’ equity) can also be viewed as the sources of the company’s assets.
The money raised by a company’s liabilities will generally have a lower cost than money raised from stockholders’ equity for the following reasons:
- Some liabilities such as accounts payable have no interest expense associated with them
- The interest on loans is deductible on U.S income tax returns, thereby reducing the net cost of the borrowed money
Therefore, liabilities that allow a company to acquire more assets to improve efficiency, safety, etc. without reducing the existing owners’ share of the business is actually a good thing..
On the other hand, liabilities will be a bad thing when they are so large that the company cannot weather a business downturn.
Example of Liabilities
Assume a corporation needs to replace its existing equipment with equipment that has the latest new technologies. The new equipment will result in better products at a lower cost. If the corporation is able to borrow the money needed at say 7% interest, the interest expense after the income tax benefit may be only 5%. If the cost savings from the new equipment does occur, the corporation’s present owners will enjoy the increased earnings without a reduction in their ownership percentages.
